THE SSP FIRM BLOG
Is Your Deferred Compensation Plan 409A Compliant?
Friday, December 15, 2017
Nonqualified deferred compensation (“NQDC”) plans are common tools for business owners with respect to the compensation and retention of key employees. Under an NQDC plan, an employee may defer receipt of compensation due in one taxable year to a later taxable year—with payment typically triggered upon the occurrence of a specific event, such as retirement. Under a well drafted NQDC plan, an employee will not be taxed on the deferred amount until the income is actually received, thereby offering potential favorable tax treatment to the employee. For example, NQDC plan payments received upon retirement are often paid in a tax year in which the retiree is in a lower tax bracket.
Employers often utilize NQDC plans to compensate and, most importantly, retain key employees by incentivizing them to stay with the company through the duration of the plan. Furthermore, unlike qualified plans, NQDC plans are not subject to any nondiscrimination rules, allowing the employer to make the plan available to only those key employees the employer chooses. NQDC plans are also used frequently by startup companies who need the flexibility to defer compensation when the company’s cash flow is tight.
While NQDC plans may provide employees and employers with mutual benefits, a poorly drafted plan may result in harsh penalties under Section 409A of the Internal Revenue Code. Under 409A, a non-compliant plan is subject to immediate taxation of the deferred amount, as well as an additional 20% excise tax. Continue reading to learn about some of the common 409A pitfalls. The following is merely an overview of common mistakes and should not be taken as an exhaustive compliance guide.
Plans Covered Under 409A
409A regulations define an NQDC plan as any plan that provides for the deferral of compensation, excluding qualified plans such as traditional retirement and pension plans. A plan provides for the deferral of compensation if the employee has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the employee in a later taxable year. Common NQDC plans include, executive compensation packages, phantom stock plans, supplemental retirement plans, stock options, and share redemption plans.
Mistakes to Avoid
1. Improper Distributions.
Too often, NQDC plans allow for impermissible distributions, such as at-will withdrawals by the employee. Under 409A, compensation deferred, pursuant to a compliant plan, may not be distributed earlier than:
- Separation from service (termination of employment)
- The date the participant becomes disabled
- A specified time (or pursuant to a fixed schedule) specified under the plan at the date of the deferral of such compensation
- A change in ownership or effective control of the company (or its assets), or
- The occurrence of an unforeseeable emergency.
In practice, an NQDC plan will often provide for distributions to be made pursuant to a fixed schedule upon the earlieroccurrence of any of the above events. Because triggering events may have an unknown future date, distributions made pursuant to a fixed schedule may be preferable for planning purposes (as opposed to the entire amount being due upon the occurrence of an uncertain triggering event).
2. Improper Funding.
409A strictly regulates the manner in which NQDC plans are funded. In general, any deferred income held in a protected or “offshore” trust for the purpose of later distributing to the employee pursuant to the NQDC plan will be deemed a transfer of property and is thereby countable as taxable income. As a general rule, assets held for the purpose of funding an NQDC plan will not be deemed a transfer of property to the extent the assets remain subject to claims of the employer’s general creditors upon insolvency.
3. Improper Acceleration of Payments.
Prior to the enactment of 409A, “haircut” provisions were standard in NQDC plans. Under such provisions, an employee could elect to receive all or part of the deferred compensation at any time at a penalized rate. Furthermore, many poorly drafted plans allow for early distributions at the election of either the employee or the plan administrator. Today, however, including such provisions in an NQDC plan will subject the plan to harsh penalties. Generally, a plan may not allow any acceleration of payment of the deferred amount after the deferral election has been made. Be sure that your existing plan does not include the once commonplace acceleration provisions.
4. Substantial Risk of Forfeiture.
Often, business owners attempt to avoid 409A by claiming the plan is subject to a substantial risk of forfeiture. A plan is not subject to the regulations of 409A to the extent it is subject to a “substantial risk of forfeiture.” Compensation is considered to be subject to a substantial risk of forfeiture if receipt of compensation is conditioned upon (i) the performance of future services or (ii) the occurrence of a condition related to a purpose of the compensation. Even when compensation under a plan is conditional, as set forth above, the law is clear that the possibility of forfeiture must be substantial. As such, simply including an illusory condition is not sufficient to create a substantial risk of forfeiture. The likelihood of forfeiture, along with all the facts and circumstances, will be considered to determine the substantiality of the risk. In practice, many NQDC plans ignore the rigor of the substantial risk analysis and assume—incorrectly—that a condition such as a non-compete clause will sufficiently impose a substantial risk of forfeiture.
At SSP, our business and estate planning lawyers have advised hundreds of business owners on succession planning and designed estate planning strategies for our business owner clients. If you’d like to explore this topic further, please contact Jeffrey G. Stagnaro via email firstname.lastname@example.org or 513-533-2981
Disclaimer: The information you obtain in this article is not, nor is it intended to be, legal advice. You should consult an attorney for advice regarding your individual situation. We invite you to contact us. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until an attorney-client relationship has been established.
 26 U.S.C. §409A(a)(1)(B)
 26 C.F.R §1.409A-1(a)
 26 C.F.R. §1.409A-1(b)
 26 U.S.C. §409A(a)(2)(A)
 29 U.S.C. §1081(a)
 26 C.F.R. §1.409A-3(j)(1)
 26 U.S.C. §409A(a)(1)(A)(ii)
 26 C.F.R. §1.409A-1(d)(1)